Tutorial 2 (Goods Market) (Answers are provided as a guide but not limited to the

following)

1. Explain what does spending multiplier represents.

Suggested answer:

The multiplier illustrates the extent to which equilibrium output will change as a
result of a given change in autonomous spending component.

 Equilibrium in the goods markets requires . This is an equilibrium

condition => where Total production (output supply) = Total output demand
in an economy.

Divide both sides by (1 − c1), we get:

 Autonomous expenditure component: [c0 + 𝐼 + G – c1T]

 Autonomous spending is positive because if T = G (balanced budget) and
c1is between 0 and 1, then (G – c1T) is positive, and so is autonomous spending.
 The term 1/(1-c1) is called the spending multiplier as it is larger than 1 when
c1 increases closer to 1.
 For example, if c1 equals 0.6, the multiplier equals 1/(1 – 0.6) = 2.5, meaning
that an increase of consumption by $2 billion will increase output by 2.5 x $2
billion = $5 billion.
2. Discuss and explain what effect a reduction in the marginal propensity to
consume has on the size of the spending multiplier.

Suggested answer:

Consumption function is a linear relation with two parameters, c0 and c1:

c1 is the marginal propensity to consume (MPC). eg, If c1 = 0.6, it means with

one additional dollar of disposable income, consumption will increase by 60
cents

A reduction in the marginal propensity to consume will cause a reduction in the

spending multiplier. When firms increase production in response to some initial
change in demand, households will increase their consumption by a smaller
amount causing the MPC falls. So, the income-induced change in demand will
be smaller causing a smaller multiplier effect.
3. Use the Y-ZZ model to illustrate the effects of a reduction in consumer
confidence on the economy. Also, explain what effect this reduction in
consumer confidence has on the economy.

Suggested answer:

The reduction in consumer confidence will cause a reduction in consumption and

demand. As demand falls, firms will cut production / output, hence decreasing
income from Y1 to Y2 as shown in graph in next page. So, this reduction in
consumer confidence in an economy will cause a lower level of equilibrium
output. The ZZ-Y graph is as follows:

ZZ

ZZ1
11

Y2 Y1
4. Suppose that, at a given level of disposable income, consumers decide to
save more. Explain what effect this decision will have on equilibrium
income. Also, explain what effect this decision will have on the level of saving
once the economy has reached the new equilibrium.

Suggested answer:

This is the paradox of saving. Here, consumption will fall causing a reduction
in demand and a reduction in output.

Saving cannot change either, because at equilibrium:

I = S + (T − G)

S cannot change because I, T or G does not change by assumption (of consumers

saving more) as they are given.

Despite the initial increase in saving at the initial level of income, saving will
return to the initial level as income falls in order to maintain the alternative
equilibrium condition: S = I. So, the initial increase in the desire to save will have
no permanent effect on the level of saving.

Policy that encourages savings might be good in medium / long run but may cause
recession in short run when savings leads to reduction in demand and output in
an economy. Such phenomena is known as the Savings Paradox.
5. Explain the difference between endogenous and exogenous variables.

Suggested answer:

Exogenous variables (independent variables) are taken as given. A factor in a

causal relationship model whose value is independent from the states of other
variables in the model. It is a factor whose value is determined by factors or
variables outside the causal system under study. For example, “rainfall” is
exogenous (explanatory variable) to the causal system of a “crop output” model
where “crop output” is an endogenous variable.

However, if we examine “rainfall” as an endogenous variable (dependent

variables determined by the model), there are causal factors that determine the
level of rainfall—so “rainfall” becomes an endogenous in a weather model—but
these factors are not themselves part of the causal model we use to explain the
level of crop output.
6. Discuss the two components of fixed investment.
Suggested answer:

Fixed investment involved purchase of capital goods like machinery, tools,

equipment, fixtures, factories for production which is the sum of the following
two components:

 Non-residential investment - expenditures by firms on capital

(CAPEX) such as commercial real estate, tools, machinery, and
factories for business production.

 Residential investment - expenditures on purchasing of

residential structures (the property) and residential equipment (fixtures
inside the property) that is owned by landlords as part of own wealth
or rented out to earn rental income.
7. There are two ways of explaining equilibrium in product market. One
being Production (output) = Demand (consumption). Explain the other
alternative way that focusses on investment and savings using algebraic
derivations.

Suggested answer:

Production (output) = Demand (consumption) approach

Investment = Savings approach